Chill Out, Folks: S&P's Downgrades Won't Break The TALF Commercial Real Estate Bond Program

Fears among credit investors that threatened ratings downgrades of commercial real estate debt could thwart government efforts to revive the market are vastly over-stated.

Standard & Poor’s warned this week that it was likely to downgrade tens of billions of dollars in triple A securities backed by recent commerical real estate loans. Some 90% of the securities backed by 2007 mortgages will likely face rating cuts. This came just about a week after, the Federal Reserve announced that it would expand the program to allow investors to buy CMBS through the Term Asset-backed Loan Facility–but said it would only be used to buy securities that are rated triple A.

The S&P announcement set off something of a panic. After the Fed’s comments on the TALF expansion, the CMBS market had been rallying and borrowing costs going down. That trend reversed with S&P’s comment. The fear is that banks will be hesitant to refinance CMBS if there isn’t a secondary market for the securities and if they can’t off-load the CMBS already on their books. Right now, private investors are proving hesitant to buy CMBS without government help. If a huge amount of the loans get downgraded, there won’t be much left over for TALF financed purchases.

This triggered a sharp fall in the value of top rated commercial mortgage-backed securities last week. 
According to Barclays Capital, the risk premiums on recent senior triple A rated CMBS have risen by more than 115 basis points this week.CMBS were trading at 835 basis points over benchmark rates, up from 720bp last week. Just one year ago, the spreads were 145bp.

S&P has been taking some unfair criticism over its announcement, including some who claim they don’t understand why S&P thinks so many CMBS borrowers will default.

“This unexpected announcement is viewed by many market participants as highly subjective and excessively arbitrary based on the company’s previous perspective,” Chip Rodgers, a senior vice president at the Real Estate Roundtable lobbying group, tells Fortune

You can understand why this would upset people with a vested interest in a rally in CMBS, especially anyone looking to roll their commerical mortgage or someone holding a big portfolio of CMBS. The S&P’s announcement broke with the official story line that everything is getting better. And it made a government plan more challenging to implement. The audacity of it all!

But, in reality, S&P’s timing of this isn’t so surprising.

It came came a week after the government announced TALF funding for CMBS, a major milestone in its support for the commercial real estate market. This created a major potential liability for S&P: if the government bought lots of bad loans based on high S&P ratings, the ratings agency could be a risk of being sued for not being strict enough. Of course the S&P wants to get out from under that potential liability by downgrading the securities ahead of government purchases.

We think the fears of the downgrades’ impact on the TALF are over-stated. There’s no reason the Fed cannot simply revise its terms, allowing for lower rated securities to be purchased. Mostly likely, the Fed will simply argue that it is still buying high quality securities because it will buy only “formerly highly rated securities that have been hit by recent market dislocations” or some such. See how easy that is? Since no one really trusts the ratings agencies anyway, basing Fed purchases on them was silly to begin with.


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